Conspiracy of Fools

by Kurt Eichenwald

  But Fastow had other priorities. During Milken’s speech, he was in London, raising money from Enron’s European banks for LJM2.

  After months of work, struggling with the labyrinths of securities laws, the restructuring of LJM1 was finished.

  The Sails proposal—first raised by CSFB at an August meeting in London—had locked in LJM1’s profits on its Enron stock. Now CSFB and Greenwich NatWest were guaranteed huge returns from LJM1’s holdings in Enron. And by transforming Enron stock into cash, Fastow obtained access to an additional twenty-five million dollars, money that the company’s directors had prohibited him from ever receiving.

  Now the ugly part—taking credit. Sure, Fastow made out like a bandit. But the bankers wanted to trumpet their success as well. After all, bonus time was rolling around in their shops, too.

  In early December, David Bermingham, a banker on the deal with Greenwich NatWest, typed an e-mail to a colleague, Gary Mulgrew, touting the deal as a Greenwich brainchild. What they had done, he wrote, “is to strip out 94% of the value remaining in the vehicle after Fastow put his grubby little fingers in the till.” And that money, he typed, went straight to profits for Greenwich NatWest.

  “What we have executed was not Enron’s idea, or Fastow’s idea, or CSFB’s idea, it was OUR idea,” he typed.

  At CSFB, bankers took a broader view: Not only had the firm made fat profits, it also had stuffed cash into Fastow’s pocket. He was sure to ship more Enron deals their way now.

  That same week, Mary Beth Mandanas, a CSFB banker, typed a report to her bosses. If LJM1 was liquidated now, she wrote, CSFB and Greenwich NatWest would walk away with almost $13 million, almost double the $7.5 million they had contributed five months before. But Fastow was the biggest winner: his one-million-dollar investment was now worth $17 million, not including $5.3 million in management fees.

  This transaction, Mandanas typed, “provided a significant return to CSFB and has further enhanced our relationship with Andy Fastow, CFO of Enron Corp.”

  Paul Riddle, a banker from First Union, was on the phone with McMahon, and he sounded annoyed. “I understand from Kelly Boots that you guys are doing a bond deal.”

  “Yup, that’s right,” McMahon replied. Here it came, he thought, a pitch for a piece of the action.

  Instead, he got a second of silence.

  Then Riddle spoke. “I’m a little confused about the process. Kelly tells me it’s going to be competitive.”

  Huh? Of course it was competitive; almost every bond offering was. Banks and investment houses bid for the lead role, with the cheapest proposal usually winning.

  “Would you expect anything different from us, Paul?”

  “Well, yeah. I was pretty much told by Fastow that by investing in LJM2, we would get the next bond deal.” LJM2. Again.

  “I gotta tell you, Paul,” McMahon said, “I was not told that by Andy, ever. I think you misunderstood. We’ve talked about it, and I’ve been telling everyone that LJM investment and Enron business are completely different.”

  Riddle’s voice hardened. “Jeff, I didn’t misunderstand Andy. I know what he told me. And he told me I would get the next bond deal if we invested in LJM2.”

  McMahon wanted nothing to do with this. “Tell you what. Call Andy, because if you cut a deal with Andy, then you should talk to Andy and get that deal done.”

  “But …”

  “Paul, did I tell you that you had a deal?”

  “No.”

  “Then talk to the person who did.”

  The moment the call ended, McMahon dialed Fastow.

  “Andy, this is Jeff. I just got a very disturbing phone call from Paul Riddle,” he said. “He says he was promised the next bond deal for investing in LJM2.”

  Fastow answered fast. “Oh, that’s just not true.”

  “Well, he said that’s what you promised him.”

  “It’s not true. Tell him no.”

  “Okay. I just wanted to make sure that’s the deal. None of this stuff is tied.”

  “None of this stuff is tied. That’s correct.”

  The call finished quickly, and McMahon hung up. He brought his hand to his face as he stared at the phone console.

  Bullshit. Riddle hadn’t been the first banker to call. McMahon had already heard the same thing—less bluntly—out of Merrill. Everybody hadn’t misunderstood.

  McMahon had no doubt. Andy Fastow was lying.

  Anxiety permeated the room. Enron’s stock had been falling—it was now in the high thirties—and the employees at the December 1 company-wide meeting weren’t happy about it. When the time came for questions, the first to be asked was what they planned to do to get the price back up.

  “I don’t ever want us to be satisfied with a stock price,” Lay replied. “I think there’s no reason to think that over the next two years we can’t double it again.”

  Later, the head of human resources, Cindy Olson, stepped up to answer questions. She received one anonymously, written on a card. She glanced it over.

  “Should we invest all our 401(k) money in Enron stock?” she read out loud. She looked up. “Absolutely!”

  She turned and smiled at Lay and Skilling. “Don’t you guys agree?”

  Skilling smiled back. “You’re doing good,” he said.

  After weeks of work, Rebecca Mark and the financial team from Azurix were ready to present their plan to save the company. A special board meeting was called at Allen Center. Mark’s message was blunt: to move forward, Azurix had to step on the gas and buy more water companies.

  “We’ve considered alternatives,” Mark said, “and we believe going for aggressive growth is the best approach.”

  The status quo would not bring the dynamic shock to the marketplace that Azurix needed. And cutting back—well, that would just pull the company out of the competition. It would be an admission of failure.

  Rod Gray, the company’s CFO, explained the numbers. Skilling could feel his temper getting the best of him as he listened. He wasn’t going to stand for another gamble based on Mark’s cocky prognostications.

  “Wait, Rod. How can you keep raising money for acquisitions without putting your credit rating at risk?”

  “There’s quite a bit of capital available out there,” Gray responded. “It would be closer to junk rates, but I’ve been assured by our bankers that it’s available.”

  With that, Skilling lost it. Junk rates! That would leave Azurix paying through the nose for borrowed cash. How could it bid against competitors who borrowed for less?

  “Rod!” Skilling snapped. “How are we going to finance competitive bidding with junk?”

  “That’s not the question I was answering. I was answering if the money is out there, and it is.”

  Skilling shot a glance at Mark.

  “All right. Rod doesn’t want to answer the question. Rebecca, can you answer it? How are you going to compete?”

  “It will be hard,” she replied calmly. “The bids we see from other companies are aggressive. They are absolutely bidding to knock Azurix out of the business.”

  Skilling sat back. He looked at the other directors and asked if management could leave the room. He wanted to speak with the board privately. Mark and the rest of the Azurix team left. The door closed behind them.

  Skilling started in, furious. “This is wrong! We do this, we’re just throwing more money away,” he said. “The only strategy that makes sense now is to significantly cut back. Cut overhead. Cut staff.”

  He stopped. The room was silent for a second. Lay broke the tension of the moment. “I agree,” he said.

  The directors all signed on. Mark had to be told she was not thinking radically enough. Cutting back on everything was the only choice. And Lay was given the job of telling her.

  The numbers at Enron for 1999 were a mess. The company had spent too much money on deals that were producing lousy returns. If it revealed its actual performance, the stock was sure to get hammered.

&nbs
p; But all those years of throwing together structured deals had created an answer. Enron had pockets everywhere, pockets that, under the accounting rules, it could treat as independent third parties. It had created its own fanciful marketplace, one where every participant only wanted what was best for Enron. There was a trust called Whitewing, with a related entity called Condor, which had plenty of cash. Of course, there was LJM1. And now there was the granddaddy of them all, LJM2, with $250 million in cash already available to hand Enron whenever it was needed.

  Still, the LJM funds wouldn’t take just anything; Fastow had already made that clear in the Cuiabá transaction, when he demanded a commitment for a future buyout. And one thing that needed to be cleared off the books—certificates in a trust called Yosemite—was the kind of low-return investment that Fastow didn’t like.

  So Enron executives turned to the Condor pocket. They began working on a deal to have Condor fork over thirty-five million dollars in its cash to Enron in exchange for Yosemite certificates. With that, the certificates would disappear from the books, and Enron would get to report tens of millions of dollars in new profits—from itself.

  Then, a problem. A junior Andersen accountant in London nixed the deal. Condor was simply too intertwined with Enron to be treated as a third party. Putting the certificates in that pocket wouldn’t change the financial reporting. Desperate, executives on the deal tracked down Fastow, begging him to let LJM2 buy the certificates—just temporarily. Fastow agreed, so long as Enron paid LJM2 a fat fee. The two sides started negotiating.

  There was plenty of grumbling. Why was this junior Andersen accountant getting in the way? On December 6, Joel Ephross, now a lawyer at Enron, e-mailed Fernando Tovar, a lawyer at Vinson & Elkins, explaining the original Condor proposal and how the accountant from Andersen—AA, as he called it—had stopped the deal.

  “So, now we have LJM, which is not in any way related to Enron (except that one of its investors is an executive, but we will not talk about that) making the equity investment,” he typed. “That will satisfy AA.”

  But that probably wouldn’t be the story’s end, Ephross wrote. “We will see if the junior person who has made this trouble is employed with AA after January 1st,” he typed. “However, very few people here are betting on that.”

  A giant American flag hung in the twelve-story atrium lobby of the Grand Hyatt Washington hotel, just steps from the capital’s convention center. It was December 7, and the hotel was packed with accountants, all in town to hear presentations from the Securities and Exchange Commission about what their profession should be doing.

  Just past eleven, Richard Walker, head of SEC enforcement, stepped up to the dais in the Constitution Ballroom. It had been a busy year for Walker. Since his boss, Arthur Levitt, had given his “numbers game” speech the year before, Walker had been working to give the words teeth. The agency had brought civil-fraud charges against officers at an array of big public companies, and then capped it off with a flourish—an accounting-fraud sweep against sixty-eight people and companies, all filed on September 28, 1999, the first anniversary of the speech.

  Those actions, Walker said, communicated the lesson. “Our message deploring the practice of earnings management has been forcefully delivered and is being embraced, I believe, by responsible practitioners and issuers.”

  Still, Walker said, some companies were continuing to pump up their numbers—crafting bogus sales with secret side agreements, overvaluing assets, hiding important facts from accountants. Auditors themselves were falling down on the job, allowing their independence to be compromised out of fear of losing fees. But the SEC was stepping up enforcement, Walker said. No longer were regulatory investigations going to be genteel matters, resolved with fines and promises to be good. Instead, the SEC was working more closely with federal prosecutors.

  “We are moving toward turning the ‘numbers game’ into a game of Monopoly,” Walker said. “Cook the books, and you will go directly to jail without passing go.”

  Three days later, at 9:35, Andersen’s offices in New Orleans, San Antonio, and Houston received an e-mail from the firm. It included a copy of an article describing Walker’s speech to the accountants. In the Houston office, someone printed out the e-mail and stuck it in a file.

  ———

  Jeff McMahon clicked up a slide.

  “These are the 1999 investments by Enron to date,” he said. “As you can see, there is a significant gap between the original estimates and actual performance.”

  It was the afternoon of December 13. The board’s finance committee was holding its last meeting of the year to hear details of Enron’s financial condition. Fastow had just given his spiel, and now it was McMahon’s turn.

  The news McMahon delivered was disturbing. Enron executives had originally estimated they would make somewhat more than one billion dollars in investments in 1999. Instead, they had exceeded that budgeted amount by almost four billion dollars.

  Fastow broke in. “Anything we did that was in excess of the approved plan required my group to find additional financing,” he said.

  A minute later, a new slide clicked up. It was headed “Year End Transactions.” There were a number of planned deals listed, worth $2.8 billion, all involving sales of assets to entities put together by Enron itself. All to help fix up the numbers before the company issued its financials.

  Bob Belfer, one of Enron’s largest shareholders, followed the flurry of financings with unease. “I find it disturbing that we’re so close to the end of the year and we have to do all of these transactions,” he said.

  Heads nodded around the room. The directors conferred, then issued instructions. Enron should never get into this kind of situation again. Not if it could be avoided.

  Three hours later, a cavalcade of black limousines moved through Houston’s post-rush-hour traffic, pulling up to the front of Saks Fifth Avenue. The Enron directors and their spouses emerged and headed inside up to Ruggles Grill 5115, an elegant Houston restaurant closed to the public that evening for Enron’s annual Christmas party.

  Inside, festive lights and holiday decorations reflected off of a wall of mirrors. A pianist added ambience, playing holiday songs. Lay greeted the guests, congratulating them for helping Enron achieve so much.

  “I’d like to commence dinner with a blessing,” he said. Everyone bowed their heads.

  “Dear God, we thank you for all the blessings you have bestowed on us,” Lay said. “And we thank you for this group of leaders, both directors and their spouses, that indeed have led Enron to another great year.”

  The prayer ended, and the guests dug in to their meals. Later, as dinner was cleared away, a voice boomed out.

  “Ho, ho, ho! Merry Christmas!”

  A man dressed as Santa Claus, loaded down with a sack, moved through the room. He called the directors to the front, asking if they had worked hard to help Enron that year. Satisfied with their answers, he presented each with a Sony digital video camera. Once Santa departed, the directors sang Christmas carols, beginning with “The Twelve Days of Christmas.” Each director played a part; Lord Wakeham, a former British Cabinet minister, was the natural to belt out “ten lords a-leaping.”

  The joviality was the perfect tonic for the directors on the finance committee. The presentations from that day had shocked some of them, but now they heard only laughter and singing and the clinking of glasses. The top executives there seemed so self-assured, high-spirited even. Maybe these numbers were just a hiccup. With Enron’s profits so strong, there really couldn’t be much reason for concern.

  “Changing the accounting on this is going to cause Enron to take a charge of thirty million to fifty million dollars,” David Duncan said. “We can’t do that.”

  He was on the phone with Carl Bass, now a member of Andersen’s Professional Standards Group. Duncan had called with a question about the restructuring of LJM1; apparently, he had misunderstood the accounting rules that applied to the options in the tran
saction. The restructuring had changed the nature of the Rhythms hedge, Bass told him, requiring Enron to recognize losses. But Duncan wouldn’t hear of it. The amount was too big.

  “I can’t go back to them on this now,” he said. “This deal is already signed or it’s about to be signed.”

  “Dave, our advice has been consistent on this and timely,” Bass replied.

  It didn’t matter, Duncan replied. He wasn’t reversing course now. Enron would keep its unearned windfall, generated solely because David Duncan didn’t know what he was doing.

  As far as Fastow and Causey were concerned, the LJM1 hedge for Rhythms had been a blazing success. And it set them to wondering: if Enron could use its own stock to lock in profits from one investment, why not for dozens?

  The money sunk into merchant investments was a hidden threat to Enron’s profitability. The market had been booming for years, but now momentum had changed. If it tanked, Enron’s losses could be horrendous. But if the company could lock in the values of its investments—if it could hedge them using Enron stock again—that danger would dissolve.

  Fastow and Causey talked over the idea with Glisan. Getting the Enron stock was the easy part, they all agreed. Maybe shares already contributed to the Whitewing fund could be drained off and assigned to another entity, which could then follow the LJM1 example in providing the hedge.

  The concept was bounced off Skilling, and he liked what he heard. Causey approached Wes Colwell, an accountant who headed the division known as transaction support, who in turn assigned the job to two accounting whiz kids, Ryan Siurek and Kevin Jordan.

  Glisan and the other accountants began brainstorming, taking turns sketching models for the hedge. It would require a lot of effort, but almost from the moment they started, the accountants knew—just knew—that this would work. They could protect Enron from future losses.